LESSON 5: WORKING CAPITAL MANAGEMENT

Objectives:
 Explain how different amounts of current assets and current liabilities affect firms'
profitability and thus their stock prices.
 Explain how companies decide on the proper amount of each current asset— cash,
marketable securities, accounts receivable, and inventory.
 Discuss how the cash conversion cycle is determined, how the cash budget is constructed,
and how each is used in working capital management.
 Discuss how companies set their credit policies, and explain the effect of credit policy on
sales and profits.
 Describe how the costs of trade credit, bank loans, and commercial paper are determined
and how that information impacts decisions for financing working capital.
 Explain how companies use security to lower their costs of short-term credit.

Background of Working Capital

The term working capital originated with the old Yankee peddler who would load up his wagon
and go off to peddle his wares. The merchandise was called "working capital" because it was
what he actually sold, or "turned over," to produce his profits. The wagon and horse were his
fixed assets. He generally owned the horse and wagon (so they were financed with "equity"
capital), but he bought his merchandise on credit (that is, by borrowing from his supplier) or with
money borrowed from a bank. Those loans were called working capital loans, and they had to be
repaid after each trip to demonstrate that the peddler was solvent and worthy of a new loan.
Banks that followed this procedure were said to be employing "sound banking practices." The
more trips the peddler took per year, the faster his working capital turned over and the greater his
profits.
This concept can be applied to modern businesses, as we demonstrate in this chapter. We begin
with a review of three basic definitions that were first covered in Chapter 3:
1. Working capital. Current assets are often called working capital because these assets "turn
over" (ie., are used and then replaced during the year).
2. Net working capital is defined as current assets minus current liabilities.
3. Net operating working capital (NOWC) represents the working capital that is used for
operating purposes. NOWC is an important component of the firm's free cash flow. NOWC
differs from net working capital because interest-bearing notes payable are deducted from
current liabilities in the calculation of NOWC. The reason for this distinction is that most
analysts view interest-bearing notes payable as a financing cost (similar to long-term debt) that is
not part of the company's operating free cash flows. In contrast, the other current liabilities
(accounts payable and accruals) are treated as part of the company's operations, and therefore are
included as part of free cash flow.

Current Asset Investment Policies

In this section, we discuss how the amount of current assets held affects profitability.
To begin, the figure below shows three alternative policies regarding the size of current asset
holdings. The top line has the steepest slope, which indicates that the firm holds a great deal of
cash, marketable securities, receivables, and inventories relative to its sales. When receivables
are high, the firm has a liberal credit policy, which results in a high level of accounts receivable.
This is a relaxed investment policy.

On the other hand, when a firm has a restricted (or light or "lean-and-mean") investment policy,
holdings of current assets are minimized. A moderate investment policy lies between the two
extremes.
We can use the DuPont equation to demonstrate how working capital management affects ROE:

A restricted (lean-and-mean) policy indicates a low level of assets (hence, a high total assets
turnover ratio), which results in a high ROE, other things held constant. However, this policy
also exposes the firm to risks because shortages can lead to work stoppages, unhappy customers,
and serious long-run problems.
The relaxed policy minimizes such operating problems, but it results in a low turnover, which in
turn lowers ROE. The moderate policy falls between the two extremes. The optimal strategy is
the one that maximizes the firm's long-run earnings and the stock's intrinsic value.
Note that changing technologies can lead to changes in the optimal policy.
For example, when a new technology makes it possible for a manufacturer to produce a given
product in 5 rather than 10 days, work-in-progress inventories can be cut in half. Similarly,
retailers typically have inventory management systems in which bar codes on all merchandise
are read at the cash register. This information is transmitted electronically to a computer that
records the remaining stock of each item, and the computer automatically places an order with
the supplier's computer when the stock falls to a specified level. This process lowers the "safety
stocks" that would otherwise be necessary to avoid running out of stock, which lowers
inventories to profit-maximizing levels.

Current Assets Financing Policies

Investments in current assets must be financed, and the primary sources of funds include bank
loans, credit from suppliers (accounts payable), accrued liabilities, long-term debt, and common
equity. Each source has advantages and disadvantages, so each firm must decide which sources
are best for its situation.
To begin, note that most businesses experience seasonal and /or cyclical fluctuations. For
example, construction firms tend to peak in the summer, retailers peak around Christmas, and the
manufacturers who supply construction companies and retailers follow related patterns.
Similarly, the sales of virtually all businesses increase when the economy is strong; hence, they
build up current assets at those times but let inventories and receivables fall when the economy
weakens.
Note, though, that current assets rarely drop to zero companies maintain some permanent current
assets, which are the current assets needed at the low point of the business cycle. Then as sales
increase during an upswing, current assets are increased, and these extra current assets are
defined as temporary current assets as opposed to permanent current assets. The manner in
which these two types of current assets are financed is called the firm's current assets financing
policy.

Approaches in Current Assets Financing Policies:

a. Maturity Matching or Self-Liquidating Approach
b. Aggressive Approach
c. Conservative Approach
d. Choosing between the approaches
The Cash Conversion Cycle
The length of time funds are tied up in working capital, or the length of time between paying for
working capital and collecting cash from the sale of the working capital.
CALCULATING THE TARGETED CCC
1. Inventory Conversion Period- The average time required to convert raw materials into
finished goods and then to sell them.
2. Average Collection Period (ACP)-The average length of time required convert to firm's
receivables into cash, that is, to collect cash following a sale.
3. Payables Deferral Period- The average length of time between the our-chase of materials
and labor and the payment of cash for them.

Illustrative Example:
The following data were taken from Company ABC’s Financial Statements:

We begin with Inventory Conversion Period:

Next, we calculate the ACP:

Next, we calculate the Payables Deferral Period,

And lastly, we combine the three periods:

CASH AND MARKETABLE SECURITIES

When most people use the term cash, they mean currency (paper money and coins) in addition to
bank demand deposits. However, when corporate treasurers use the term, they often mean
currency and demand deposits in addition to very safe, highly liquid, marketable securities that
can be sold quickly at a predictable price, and thus be converted to bank deposits." Therefore,
"cash" as reported on balance sheets generally includes short-term securities, which are also
called "cash equivalents." Note that a firm's marketable security holdings can be divided into two
categories:
(1) operating short-term securities, which are held primarily to provide liquidity and are bought
and sold as needed to provide funds for operations, and
2) other short-term securities, which are holdings in excess of the amount needed to support
normal operations.
Highly profitable firms such as Microsoft often hold far more securities than are needed for
liquidity purposes. Those securities will eventually be liquidated, and the cash will be used for
such things as paying a large one-time dividend, repurchasing stock, retiring debt, acquiring
other firms, or financing major expansions. This breakdown is not reported on the balance sheet,
but financial managers know how much of their securities will be needed for operating versus
other purposes. In our discussion of net working capital, the focus is on securities held to provide
operating liquidity.

CURRENCY
Fast-food operators, casinos, hotels, movie theaters, and a few other businesses hold substantial
amounts of currency, but the importance of currency has decreased over time due to the rise of
credit cards, debit cards, and other payment mechanisms. Companies such as McDonald's need
to hold enough currency to support operations, but if they held more, this would raise capital
costs and tempt robbers. Each firm decides its own optimal level, but even for retailers, currency
generally represents a small part of total cash holdings.

DEMAND DEPOSITS
Demand (or checking) deposits are far more important than currency for most businesses. These
deposits are used for transactions paying for labor and raw materials, purchasing fixed assets,
paying taxes, servicing debt, paying dividends, and so forth. However, commercial demand
deposits typically earn no interest, so firms try to minimize their holdings while still ensuring
that they are able to pay suppliers promptly, take trade discounts, and take advantage of bargain
purchases. The following techniques are used to optimize demand deposit holdings:
1) Hold marketable securities rather thon demand deposits to provide liquidity.
When the firm holds marketable securities, the need for demand deposits is reduced. For
example, if a large bill requiring immediate payment comes in unexpectedly, the treasurer
can simply call a securities dealer, sell some securities, and have funds deposited in the
firm's checking account that same day. Securities pay interest, whereas demand deposits
do not, so holding securities in lieu of demand deposits increases profits.
2) Borrow on short notice. Firms can establish lines of credit under which they can borrow
with just a telephone call if and when they need extra cash.
Note, though, that they may have to pay fees for those commitments, and the cost of
those fees must be considered when deciding to use borrowing capacity rather than
securities to provide liquidity.
3) Forecast payments and receipts better.
4) Speed up payments.
5) Use credit cards, debit cards, wire transfers, and direct deposits
6) Synchronize cash flows

CASH MANAGEMENT
Efficient cash management is a core aspect. Companies need to strike a balance—having
enough cash to cover expenses while avoiding excess idle cash, which could be invested more
productively.

ACCOUNTS RECEIVABLE
Managing receivables involves collecting payments from customers promptly. This might
include offering discounts for early payments or establishing clear credit policies.

INVENTORY MANAGEMENT
Balancing inventory levels is crucial. Too much can tie up capital, while too little can lead to
production delays. Techniques like Just-In-Time (JIT) can be employed.

ACCOUNTS PAYABLE
Companies should optimize payment terms with suppliers. Negotiating favorable terms allows
for better cash flow management.
WORKING CAPITAL RATIOS
Ratios like the current ratio and quick ratio help assess a company's ability to meet short-term
obligations. These are vital indicators for investors and creditors.

BANK LOANS
Promissory Note- A document specifying the terms and conditions of a loan, including the
amount, interest rate, and repayment schedule.
A. Amount. The amount borrowed indicated in the PN.
B. Maturity. The specified term of the loan.
C. Interest Rate. The interest that should be paid on top of the principal.
D. Interest only versus amortized. Loans that are interest only means that the interest is paid
during the life of the loan, with all the principal repaid when loan matures, or amortized,
meaning that some of the principal is repaid on each payment date.
E. Frequency of interest payments. If the note is on an interest-only basis, it will indicate
how frequently interest must be paid. Interest is typically calculated daily but paid
monthly.
F. Discount interest. Most loans call for interest to be paid only after it has been earned, but
banks also lend on a discount basis, where interest is paid in advance. On a discount loan,
the borrower actually receives less than the face amount of the loan, and this increases its
effective cost.
G. Add-on Loans. Interest charges over the life of the loan are calculated and then added to
the face amount of the loan.
H. Collateral. Security for the loan. Ex: equipment, buildings, accounts receivable or
inventories.
 I. Restrictive Covenants. The note may also specify that the borrower must maintain certain
ratios at or better than the specified levels, and it spell out what happens if the borrower
defaults on those covenants. Default provision allows the lender to demand immediate
payment of the entire loan balance. Also, the interest rate might be increased.
J. Loan Guarantees. If the borrower is a small corporation, the bank will probably insist that
its larger stockholders personal guarantee the loan.

CALCULATING BANK’S INTEREST CHARGES: REGULAR (or SIMPLE) INTEREST

Regular, or Simple Interest-The situation when interest only is paid month.
Illustrative Example:
Assume a loan of P10,000 at the prime rate (currently 5%) with a 360-day year. Interest must be
paid monthly, and the principal is payable “on demand” if and when the bank wants to end the
loan. Such a loan is called a regular or simple interest loan.

=.05/360
=0.000138888889

To find the monthly interest payment, the daily rate is multiplied by the amount of the loan, and
then by the number of days during the payment period. For our illustrative example, the daily
charge would be P1.38888889, and the total for a 30-day month would be P41.67.

=0.000138888889 x P10,000 x 30 days = 41.67

The effective interest rate on a loan depends on how frequently interest must be paid- the more
frequently the interest is paid, the higher the effective rate. If interest is paid once a year, the
nominal rate also will be the effective rate. However, if interest must be paid monthly, the
effective rate will be:
(1+.05/12)^12 -1 =5.1162%.

CALCULATING BANKS’ INTEREST CHARGES: ADD-ON INTEREST

Illustrative Example:
Suppose you borrow P1,000,000 on an add-on basis at a nominal rate of 3% to buy a car, with
the loan to be repaid in 12 monthly installments. At a 3% add-on rate, you would make total
interest payments of P1,000,000(0.03)=P30,000. However, because the loan is paid off in
monthly installments, you would have the use of the full P1,000,000 for only the first month, and
the outstanding balance would decline until, during the last month, only 1/12 of the original loan
was still outstanding. Thus, you would paying P30,000 for the use of only about half the loan’s
face amount, as the average usable funds would only about P500,000. Therefore, we can
calculate the approximate annual rate as 6%.

=30,000/(P1,000,000/2) = 6%

COMMERCIAL PAPER
Commercial paper refers to unsecured, short-term debt issued by corporations and financial
institutions. It typically has a maturity of less than 270 days. Companies use commercial paper to
meet short-term financial obligations like payroll and accounts payable.

ACCRUALS (ACCRUED LIABILITIES)

Accruals are continually recurring short-term liabilities, especially accrued wages and accrued
taxes.
Accruals arise automatically from a firm’s operations; hence, they are spontaneous funds. For
example, if sales grow by 50%, accrued wages and taxes should also grow by about 50%.
Accruals are “free” in the sense that no interest is paid on them.